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UACES 42nd Annual Conference

Passau, 3-5 September 2012

Conference papers are works-in-progress - they should not be cited without the author's

permission. The views and opinions expressed in this paper are those of the author(s).


Does Charter Competition Foster


A Difference-in-Difference Approach to

European Company Law Reforms

Reiner Braun

Finance Working Paper N°. 308/2011

Technische Universität München - Center for

May 2011

Entrepreneurial and Financial Studies Horst Eidenmüller University of Munich and ECGI Andreas Engert University of Mannheim and ECGI Lars Hornuf University of Munich © Reiner Braun, Horst Eidenmüller, Andreas Engert and Lars Hornuf 2011. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source.

This paper can be downloaded without charge from:

http://ssrn.com/abstract_id=1827962 www.ecgi.org/wp Electronic copy available at: http://ssrn.com/abstract=1990189 http://ssrn.com/abstract=1827962 ECGI Working Paper Series in Finance Does Charter Competition Foster Entrepreneurship?

A Difference-in-Difference Approach to European Company Law Reforms Working Paper N°. 308/2011 May 2011 Reiner Braun Horst Eidenmüller Andreas Engert Lars Hornuf We gratefully acknowledge helpful information on the relevant Polish reform from Anna Rojewska of the Morawski & Wspólnicy law firm (Warsaw) and on the Hungarian reform from Emese Szilagyi of the Weitnauer law firm (Munich). We are indebted to Scott Baker, Douglas Cumming, Andreas Michl as well as the participants in the CFS/LEMF Summer School ´Law and Economics of Contracts´, the 8th Annual Conference of the German Law and Economics Association and the 6th Annual Conference of the Italian Society of Law and Economics.

© Reiner Braun, Horst Eidenmüller, Andreas Engert and Lars Hornuf 2011. All rights reserved.

Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission Electronic copy available at: http://ssrn.com/abstract=1990189 http://ssrn.com/abstract=1827962 Abstract We study how company law reforms, particularly the reduction or abolition of minimum capital requirements, in various European jurisdictions affect the decision of entrepreneurs to incorporate by means of a private limited liability company (LLC). Since the landmark rulings of the European Court of Justice (ECJ) in the years 1999, 2002 and 2003, entrepreneurs in the European Union (EU) have been able to choose the country of incorporation independently of their real seat. As a result, the proliferation of the UK private company limited by shares has posed a competitive threat to many European legislators. We analyze whether the reforms adopted in Spain, France, Hungary, Germany and Poland have promoted the popularity of domestic legal forms and encouraged entrepreneurship more generally. Using a difference-in-difference approach, we record a strong impact in both respects, especially if the minimum capital requirement was reduced or abolished.

Keywords: entrepreneurship, regulatory competition, charter competition, corporate mobility JEL Classifications: G38, K22

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Electronic copy available at: http://ssrn.com/abstract=1990189

1. Introduction Entrepreneurial activity is a key driver of economic growth and development. Workable policies to encourage business ventures are, therefore, in strong demand. In this regard, the entrepreneurship literature has recently taken a vivid interest in regulation as a potential constraint on start-up activity. The new line of inquiry originates from the more general research on the impact of law and regulation on economic development. The law and finance literature holds that „law matters‟ for the financing of economic activities and hence for the comparative success of economies (La Porta et al. 1997, 1998). To make their case, law and finance scholars try to identify a link between legal rules and institutions in the various jurisdictions and economic performance. While their research has covered many fields of law and regulation, one major strand has been the „regulation of entry‟ (Djankov et al. 2002). The World Bank has been foremost in promoting a strategy of legal reform to foster economic development. Since 2002, it has been monitoring the legal and regulatory conditions for „doing business‟ in various economies (World Bank/International Finance Corporation 2010).

The general claim of this research is that stricter regulation tends to stifle start-up activity. Yet its empirical underpinning is rather weak as it rests mostly on cross-sectional data (see the survey in Djankov 2009, pp. 190-193).2 Accordingly, it is hard to tell if less onerous regulation leads to more entrepreneurship or if countries with more start-up firms, for whatever reasons, tend to be less restrictive. Recently, Levie and Autio (2010) employ a panel of 54 countries from 2004 to 2008 to show that a very general measure of „regulatory burden‟ (including aspects of labor and bankruptcy law) exerts a negative influence on entrepreneurial activity.

Major changes in European company law during the last decade provide the opportunity for a fresh look at the interaction of legal restrictions and entrepreneurial activity. With a number of groundbreaking decisions starting in 1999, the European Court of Justice (ECJ) enabled firms to opt out of the national company law of their home country and instead to avail themselves 2 For instance, in a cross-section of 95 countries, Klapper and Love (2010) report a negative relationship between the cost of incorporation (i.e., number of procedures, time and expenses) in 2004 and the average number of LLC incoporations relative to the working population during 2005-2009. Similarly, in their survey on more than 3 million companies in 21 European countries, Klapper et al. (2006) find that high costs of incorporation reduce the number of new firms. By contrast, using data from 39 countries, van Stel et al.

(2007) find only the minimum capital requirement to bear a statistically significant relation with entrepreneurial activity while the number of procedures, the time and expenses needed for incorporation appeared to be irrelevant.

2 Electronic copy available at: http://ssrn.com/abstract=1827962 of the company law of another European Union (EU) member state.3 Legal constraints on company formation have ceased to be binding insofar as other company laws offer less restrictive rules. Conversely, states may find it in their interest to market their company law to foreign firms or, at the very least, to avoid losing their own firms to foreign jurisdictions. As a consequence, states can now compete for the company law most attractive to entrepreneurs and firms generally. Whether such regulatory competition leads to desirable results overall is an important policy question for European company law and the EU legislator. Evidently, if one were able to show that regulatory competition increases entrepreneurial activity, this would count as a substantial benefit. At the same time, it would validate the claim that „law matters‟: If the opportunity to opt out of a restrictive legal regime causes more new firms to be set up then, apparently, cutting regulation is a way to foster entrepreneurship.

State competition in company law („charter competition‟) has been around in the United States (US) for more than a century. Accordingly, there is a large amount of empirical work on state competition for large public companies‟ charters in the US (for an extensive survey see Bhagat and Romano 2007, pp. 970-987). Surprisingly little effort has been devoted on incorporation choices of small firms. Notable exceptions in the recent US literature are Dammann and Schündeln (2008, 2009) and Kobayashi and Ribstein (2010). These studies do not, however, relate charter competition to the regulatory barriers faced by start-up firms. By contrast, Becht et al. (2008) provide a careful and highly influential analysis of the incorporation choices of entrepreneurial firms in the EU following the ECJ‟s landmark cases.4 Using a difference-in-difference method, they show that the United Kingdom (UK) attracted a large number of incorporations from other EU member states (but not from jurisdictions outside the EU unaffected by the ECJ‟s rulings). They also find that incorporations in the UK are driven mainly by the minimum capital required to establish a limited liability company (LLC) in other jurisdictions; the UK does not impose any such requirement. Evidently, startup firms have taken advantage of the new opportunities created by the ECJ.

In this article, we revisit the matter and extend the analysis of Becht et al. (2008) in two important directions: After the ECJ unleashed charter competition, at least five European 3 See ECJ, Case C-212/97 Centros Ltd. v. Erhvervs- og Selskabsstyrelsen [1999] ECR I-1459; Case C-208/00 Überseering BV v. Nordic Construction Company Baumanagement GmbH [2002] ECR I-9919; Case CKamer van Koophandel en Fabrieken voor Amsterdam v. Inspire Art Ltd. [2003] ECR I-10155.

4 In his survey, Djankov (2009, p. 193) highlights Becht et al. (2008) as the „most creative study linking business registration and entry regulation‟.

3 jurisdictions have enacted company law reforms to facilitate LLC incorporations. All reforms aim at reducing formalities or accelerating the process of establishing an LLC. Four out of five states decreased or abolished the statutory minimum capital, i.e. the requirement that shareholders must provide their LLC with a minimum amount of equity funding. The reforms seem to respond to the new competitive pressure exercised by less restrictive company law jurisdictions, notably the UK. Figure 1 depicts the average minimum capital over all national company laws in the EU, divided in two subsets: Jurisdictions adhering to the „incorporation theory‟ permitted start-up firms – in principle at least – to incorporate abroad even before the ECJ‟s landmark decisions. Conversely, many European jurisdictions follow the „real seat theory‟ and refuse domestic firms the right to incorporate out of state. The new ECJ case law effectively ruled out the „real seat theory‟ in relation to other EU member states. It is suggestive that the „real seat‟ jurisdictions maintained a markedly higher level of minimum capital before the ECJ exposed them to competitive pressure from other jurisdictions. After the rules of the game had changed, the average minimum capital declined in both groups of jurisdictions. (The ECJ struck down not only the „real seat theory‟ but also impediments to out-of-state incorporations in certain countries following the „incorporation theory.‟) We evaluate whether, by enacting company law reforms, the five jurisdictions succeeded in defending their home market against competition from the main contender, the UK private LLC.5 Our study for the first time considers the supply-side of charter competition in the EU and its interaction with the demand side. We thus provide both more detail and support to the original findings of Becht et al. (2008).

Using a difference-in-difference approach, we show that EU member states can in fact promote their domestic LLC form by facilitating incorporations, particularly by cutting the statutory minimum capital. To this end, we collect time-series data on incorporations before and after the legal reforms in Spain, France, Hungary, Germany and Poland. Studying the effect of statutory amendments enables us to define a very clearcut event, namely the specific day when the new law entered into force. Looking at five independent events in different countries during the decade from 2000 to 2010 should increase the external validity of our results.

5 Becht et al. (2008) show that one important reason for the UK‟s leading position is the absence of a minimum capital requirement for private LLCs.

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8.000 6.000 4.000 … 2009 2000 2001 2002 2003 2004 2005 2006 2007 2008 2010

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In addition, we confront the critical issue whether facilitating LLC incorporations actually increases the number of start-up firms. Becht et al. (2008) have shown that entrepreneurs from other EU member states have chosen to incorporate in the UK once the opportunity presented itself. Yet the rise in UK incorporations may have come at the expense of the domestic LLC forms in the entrepreneurs‟ home states. Also, entrepreneurs do not have to incorporate to start a business. They can establish a firm in the form of a partnership or in their own name, i.e. as a sole proprietor. To demonstrate that lower incorporation costs spur new firm creation, we consider the possible substitution effects. We do so for the five reform countries by looking at the effect not only on domestic LLC incorporations but also on partnerships and UK private LLCs. When we include these substitutes, the impact of the reforms tends to slightly weaken but generally does not vanish. Apparently, the reforms succeeded in stimulating start-up activity rather than just luring firms away from other legal forms. It follows that facilitating LLC incorporations may be a policy tool to foster entrepreneurship.

The paper comes in 5 more sections. In section 2 we specify the hypotheses using a simple theoretical model on entrepreneurship and the costs of regulation. Section 3 describes the

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